Law Society of South Australia – Commercial Construction Law Conference 2009

Jeanie Elliott

Construction as a way to make a living carries more than its fair share of risk. Margins are low and uncertainties are high; any one of a number of unknowns can wipe out all of the profit on a job for the contractor or lead to huge cost increases for the owner party. Contract drafters have tried to address these risks by producing long and complex contract documentation that purports to cover every possible eventuality and to achieve a full risk transfer from one party to another, including passing on risk that the other party is unable realistically to price, manage, and/or afford.

There have been a number of reports around the world urging less reliance on contracts as a means of achieving required project deliveries. A review of a number of significant projects that have in fact gone wrong, and which have ended in dispute, suggests that bespoke contract documents or lengthy amendments to standard form contract are less effective than those drafting them hope and expect in protecting their position in such circumstances. That mismatch is at its most acute in long, one-sided bespoke contracts.

A contract can only ever be one of a raft of risk management tools for your client and it is a mistake to believe that the best protection you can give is a contract that transfers all risk to the other contracting party. The more lengthy, complex and onerous the contract, the less useful it will be for this purpose.

There is a significant extent to which the courts can and do regularly circumvent a literal reading of one sided or onerous contract conditions by applying a number of methods, including principles of misrepresentation, quantum meruit, negligence, breakdown in contractual machinery, the principles of construction, the doctrines of penalties and prevention and the practical exigencies of delay analysis can and do intervene, such that the end result of disputes is often markedly different from that envisaged by the express words of the contract.

This paper suggests that the place to begin the task of drafting a construction contract is by identifying your client’s objectives against an understanding of:

(a) the real areas which cause cost and time increases in construction projects; and

(b) what features of a construction project make it inherently more risky than others.

There is a delicate balance to be struck between producing contract conditions which protect your client without causing tender prices to be inflated to cover the risk transfer and your client paying for risks that might never eventuate. A better understanding of what the risks are can help achieve that balance and produce a better outcome for all project participants.

It is worth having a look back at first principles to remind ourselves that the legal requirements for a binding contract are actually quite simple, and a far cry from the 100 or 200 page long documents that have become the norm on construction projects.

Essential Elements

What do you need to create a binding contract? The following elements:

An intention to create a legal relationship;

Legal capacity of the parties to enter a contract;

Genuine consent of the parties;

A legal purpose;

An offer and a matching acceptance;

Valuable consideration;

Sufficiently certain terms.

If all of the above elements and terms are present, a contract exists. In most cases involving construction projects, at least the first 4 essential elements are uncontroversial.

Virtually all commercial dealings relate to the formation of legal relationships and the law presumes that this is the case. Social agreements are not binding contracts; e.g. a man’s promise to pay his future wife a dress allowance of £100 per year was not contractually binding on the basis that it was not the intent of the parties to enter into legal relations.

Legal capacity simply means that the contracting parties are either adult of sound mind, or in the case of a company, registered under corporations law.

Contracts are sometimes entered into not as a result of genuine consent being given but under duress or undue influence; this is uncommon in the construction industry. There is plenty of commercial pressure, but true duress is unusual.

Contracts must be legal (e.g. a contract to kill someone is not legally binding). Again, this issue very seldom arises in the construction context.

Valuable consideration is rarely a problem either as most construction contracts specify either a price to be paid or a mechanism for working out what is payable.

The Controversial Elements

An Offer and a Matching Acceptance

It is remarkable that projects worth many millions of dollars are commenced, and even completed, without the parties reaching consensus as to what documents form the terms of the contract or on occasion even forming the contract.Sometimes this is deliberate, with one party “keeping the contract ball in the air” and sometimes due to administrative inefficiency or oversight.

The process of negotiating and finalising a building contract can be very lengthy, occurring over a number of months or longer. The essence of a building contract, like any other, is agreement. Whether or not the parties are in agreement and a contract has been concluded during this period – and if so, on what terms – is a key area of dispute in the construction industry.

Keating on Building Contracts sets out the following series of the questions to be asked during the exercise of trying to work out whether a contract has been concluded:

(a) in the relevant period of negotiation, did the parties intend to contract?

(b) at the time when they are alleged to have contracted, had they agreed with sufficient certainty upon the terms which they then regarded as being required in order that a contract should come into existence?

(c) did those terms include all the terms which, even though the parties did not realise it, were in fact essential to be agreed if the contract was to be legally enforceable and commercially workable?

(d) was there a sufficient indication of acceptance by the offeree of the offer as then made complying with any stipulation in the offer itself as to the manner of acceptance?

If the answer to all those questions is yes, then the likelihood is that a binding contract exists. On such an approach the court’s task is to review what the parties said and did and from that material to infer whether the parties’ objective intentions as expressed to each other were to enter into a mutually binding contract.

Clarity of Terms – Scope of works

The terms of the contract generate many disputes. In commercial contracts, the terms are usually written down so that there can be no doubt about the words that have been agreed. However, there can still be disputes about what the agreed words mean. Where contracts are not in writing, there is much more scope for dispute because, in the event of a dispute, the parties often disagree as to what was said when the contract was made.

If the terms of the contract are too uncertain, it may be that the contract, or part of it, is not binding. Uncertainty can arise from imprecise language in the agreed terms.

For example, a contract to grant a lease on a service station “on reasonable terms as normally govern such a lease” was found to be too uncertain and therefore void.

Essential Terms

In addition, to create a binding construction contract the essential terms must be agreed. Agreement as to parties, price, time and description of works is normally the minimum necessary to make the contract commercially workable although the obligation to complete within a reasonable time will be implied if the other essential terms are agreed.

Uncertainty of contract terms is particularly prevalent in construction contracts for a number of reasons:

(a) The complexity of the contract subject matter

(b) The number and extent of risks being allocated

(c) That the contract normally consists of a number of different documents or different versions of the same document – program, drawings, specification etc . It is not unusual for these documents to be mutually inconsistent in at least some respects;

Risk allocation

One of the primary purposes of construction contracts is to agree in advance the allocation of the risks associated with the project.

Where parties are fully informed as to the risk that is to be assumed, it is likely that profit margins will reflect the degree of risk – the higher the risk, the higher the return. A willingness to assume significant risk without corresponding financial reward is sometimes demonstrated when the market is very tight but it is unlikely to be a successful long term strategy.

The recent trend has been for the principal to put forward contract terms that allocate risk to parties who are unable to manage or bear the risk. Often the terms will be based on one of the industry standard form contracts but with extensive amendments, the aim of which is to alter the risk allocation. In the No Dispute report prepared by the NPWC/NBCC joint working party as long ago as May 1990, the authors considered that the basic principles of allocating obligations and/or risks for all projects should be those developed by the international construction lawyer Max Abrahamson. Those principles dictated that a party to a contract should bear a risk where:-

The risk is within the party’s control;

The party can transfer the risk, e.g. through insurance, and it is most economically beneficial to deal with the risk in this fashion;

The preponderant economic benefit of controlling the risk lies with the party in question;

To place the risk upon the party in question is in the interests of efficiency, including planning, incentive and innovation;

If the risk eventuates, the loss falls on that party in the first instance.

The factors that drive the contractual allocation of risk have been restated as follows:

Which party can best control the events that may lead to the risk occurring?

Which party can best manage the risk if it occurs?

Whether or not it is preferable for the employer to retain an involvement in the management of the risk.

Which party should carry the risk if it cannot be controlled?

Whether the premium charged by the transferee is likely to be reasonable and acceptable.

Whether the transferee is likely to be able to sustain the consequences if the risk occurs.

Whether, if the risk is transferred, it leads to the possibility of risks of different nature being transferred back to the employer.

Risks generally fall into three categories:

Risks the principal is best placed to manage (e.g. project related risks such as development approval risk);

Risks the contractor is best placed to manage (e.g. construction related risks);

Neutral risks (e.g. weather).

The obligations and risks that are within the control of the Principal should be borne by the Principal, and the obligations and risks that are within the control of the Contractor should be borne by the Contractor. Neutral risks can be shared, for example, a mechanism granting the Contractor an extension of time so that they are protected from liability for liquidated damages, but not allowing the Contractor any recovery of delay costs so that the Principal is not financing the whole of each and every delay that is outside the Contractor’s control.

Clear identification of the obligation and/or risk is essential in any method of risk allocation. This lessens the likelihood of disputes. [increase the risk][decrease the risk]There are Work scope is uncertain.

Number of specialists within the workforce e.g. professionals; technicians; management.

Degree of innovation. The extent to which the project involves innovative solutions, and the level of familiarity and experience available.

New development or refurbishment and extension of existing facilities (ongoing business activities).

The complexity of the client-side arrangements. Single business stream within department or cross-cutting involving multiple departments.

Infrastructure and site characteristics.

Risk Identification – assessing from the outset the areas of vulnerability.

Early intervention by experienced trouble-shooter.

Understanding and compliance with requirements of the contract, both administrative and substantive Time at the outset to take selves and subcontractors through a risk matrix.

Ensuring all contract documents are clear – time spent at the outset going through in detail.

Selective use of incentives

Consultants to fill knowledge gaps

Regular site presence

Early legal involvement

Quick, workable dispute resolution process

Limitations of liability

Testing with scenarios.

Understanding sources of construction disputes

Process problems

People issues

Project uncertainty

Need to address the source or resolving the dispute will become increasingly

Difficult

Resource-intensive

Likely to result in an unsatisfactory solution on all sides.

Close relationship and involvement with principal/consultant team

Good paper trail – records, records, records

Liquidated damages (cap)

Novation of Designers/Subcontractors

Indemnities

Insurance

Special contract conditions to link performance to outcomes or alter risk allocation

Conclusion

Anecdotal experience over many years suggests that the more money that is spent with the lawyers preparing a “bulletproof” contract, the more likely a project is to end up in litigation. In a sense, there nothing more to this than the observation that the more time you spend in hospital, the more likely you are to be ill. But there remains an underlying point: that adversarial and onerous contract conditions typically do not work in practice, at any rate against a determined and well-advised party. It is perhaps no coincidence that the recent prevalence of onerous contract condition has been matched by an increased interest in alternative procurement routes solutions such as alliancing. But alliancing demands a significant upfront investment and is not going to be suitable for all projects. Another solution to sit alongside the more radical methods would be to rethink onerous contract conditions, and for the parties to work together in the context of contract terms that are fair and reasonably workable.

Cohen v Cohen (1929) 42 CLR 91.

for a recent example see ABB Engineering v Abigroup [2003] NSWSC 665 – a dispute relating to the construction of the roof of the Olympic Superdome, where it was found that no contract existed notwithstanding the completion of $3.2 million of work.

Keating on Construction Contracts

“If some particulars essential to the agreement still remain to be settled afterwards there is no contract”; Lord Blackburn in Rossiter v Miller (1878) 3 App.Cas. 1124 at 1151, HL. 8

If a particular term in a contract is too vague, leading to uncertainty, and the remainder of the contract can be of effect in the absence of that term, a court might sever the uncertain term from the contract.